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Semi-Case Study / Background on Aimia $GAPFF

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Semi-Case Study / Background on Aimia $GAPFF Semi-Case Study / Background on Aimia $GAPFF Almost exactly a year ago (August 15th, to be exact) I started research on (and took a small position in) Aimia (ticker: GAPFF, disclosure: long the equity and preferreds in roughly equal size). The investment has had ups and downs (the prior management team almost ran the company into the ground through a combination of incompetence and one of the worst transactions I've ever seen, but fortunately some shareholders got involved and brought in a new management team). Today, the company is in one of the weirdest special situations I’ve ever seen: they are balancing two hostile offers (one from Air Canada plus their credit card companies ("the consortium") for their Aeroplan program and one for theirMexican PLM investment) while simultaneously striking partnerships to prep to relaunch their Aeroplan program once Air Canada leaves in 2020. I wanted to highlight the company because the situation here is extremely rare (I can’t remember anything with two hostile bids on the table before) and it could evolve in a lot of different ways. Both theAir Canada and Aeromexico deals appear to be off the table currently, but I think the strategic value of all of Aimia’s assets are way higher in the hands of their respective bidders than as a standalone, so if I had to guess I’d say eventually everyone comes back to the table and Aimia is broken up and sold (I think the optimal outcome for all parties is for Aimia to sell off all of their parts outside of Aimia and then re-engage with / sell the whole company (which is now basically Aimia and some cash) to the Air Canada consortium as I think that would result in the least tax leakage and highest shareholder value). Still, I could be convinced of anything ranging from the company launching a wildly successful standalone program in a few years to the company flaming out spectacularly once AC leaves the program. FWIW, Aimia board member Mittleman’s Q2’18 letter includes an updated SOTP that pegs Aimia’s value at ~C$10/share, which is significantly above today's price of <C$4.00/share. Last year I posted a “case study” on Tangoe after it got acquired; in that vein (and with the company currently "in play" and the situation rapidly evolving) I figured I’d post last year’s Aimia write up. So below is my write up from last year (written end of August 2017). With the benefit of hindsight, I think the post was way overoptimistic on several things (in particular, I was early on Aeroplan’s stabilization, way overestimated the value of the international programs, and generally was wrong on management’s urgency for finding a new partner and general competence) but it seems it was relatively spot on in the thing that mattered most: the strategic value of Aeroplan and (some) of its parts. Enjoy! (PS- lest you think I am doing this simply to pat myself on the back, I feel like I have been pretty open with admitting to mistakes in the past and I’ll aim to post some negative case studies in the future; posting this is much more an effort to share knowledge as I did a lot of research into loyalty programs that I think investors might find useful / helpful for general background on the situation, and I've generally found a bit of misinformation / misunderstanding on Aimia and the event set up that this post might help a bit with). Last year's write up starts below th On May 10 , disaster struck for Aimia shareholders (AIM in Canada; GAPFF in America. Disclosure: long). Air Canada, Aimia’s largest redemption partner, had decided not to renew their partnership; instead, Air Canada was planning on launching their own loyalty program when their contract expired in June 2020. Aimia shares tanked in response as investors projected a bleak future for Aimia without Air Canada. It’s my belief that the massive sell off is an overreaction, and investors today are presented with a unique opportunity to buy what could be a fantastic business at a discount to run off value. Some basics: Aimia owns and operates loyalty programs and loyalty / marketing analytics. Most of Aimia’s value comes from Aeroplan, Canada’s “premier” coalition loyalty program. A coalition program basically works like this: A consumer joins the program. Every time they spend money at a business that participates in the program (a “coalition partner”), that coalition partner buys a loyalty unit (a mile) from Aimia / Aeroplan and puts it into that customer’s Aeroplan account. Once the customer has accumulated enough miles (~30 months for the average Aeroplan customer), they can cash those miles in for a reward (in general, a flight). At that point, Aeroplan will buy the reward and give it to the consumer. The loyalty program obviously has the potential to be a great business. Aimia collects the cash for the miles up front and doesn’t have to give the customers anything for a long period of time (30 months in the Aeroplan example), creating a massive amount of float. And, much like with gift cards, a significant amount of the miles that consumers generate are never used (known in the industry as “breakage”); since those miles have already been purchased by the coalition partner, that breakage represents basically 100% profit for the loyalty program. At this point you’re probably wondering: if Aimia is such a good business, then why does Air Canada leaving Aeroplan matter? Well, Air Canada is Canada’s largest airline, and Aeroplan is a loyalty program designed to get people reward flights (notice the “Aero” in their name!). Air Canada represented 11% of Aimia’s gross billings (loyalty units purchased) and 47% of Aimia’s redemptions in 2016; however, those numbers actually understate just how important Air Canada is to Aeroplan, as Aimia is a global company with several different loyalty programs. If we were to just look at the Americas segment (the segment where Aeroplan is located), Air Canada represented 19% of Aimia’s Americas revenue and a whopping 82% of Aimia’s Americas redemptions in 2016. When the numbers are presented like that, you can see why the market is so concerned: not only is Aimia / Aeroplan losing a huge chunk of their revenue, but they are also losing by far their most popular redemption option. What good is a loyalty program designed for people who want flights if the program doesn’t have any flights? Losing ~20% of Aeroplan’s revenue and ~80% of their redemption options may sound bad, but it may actually undersell the risk to Aeroplan. Remember, getting paid for miles 30 months before consumers redeem those miles creates an incredible amount of float. However, Aimia doesn’t just keep all of the money on their balance sheet; instead, they have historically used that cash to buy back a ton of shares and pay out a lot of dividends. So that massive float represents a real liability that Aeroplan must continually generate cash / more float to replenish. If that float ever were to decrease significantly, Aeroplan may not have enough cash on hand to meet redemptions, which makes Aeroplan vulnerable to a “run on the bank” type scenario where the loss of Air Canada causes all consumers to redeem their miles en masse before Air Canada goes away. At June 30, 2017, Aimia had ~$3.3B CAD in deferred revenue (almost exclusively miles to be redeemed) on their balance sheet. Not all of that is related to Aeroplan given they run several loyalty programs worldwide, but the bulk of the liability is Aeroplan. If everyone rushed to redeem those miles at once, Aimia would be unable to meet that obligation and Aeroplan would collapse. And remember: bank runs can be self- fulfilling, as one person panicking and pulling their money can cause two more, who cause four more, who cause eight more…. Until the whole thing collapses. In the wake of Air Canada pulling out, Globe and Mail ran a series of articles highlighting ways to replace Aeroplan and frequent flyers asked if they should dump Aeroplan, so a bank run is clearly in play here as well. So clearly losing Air Canada is an existential threat to the Aeroplan program, but I actually think investors today have enough information to determine that the risk of a bank run has passed and there’s a very good chance Aeroplan will remain viable / profitable after Air Canada leaves in 2020. Let’s start with why I think a bank run is off the table: Aimia already reported Q2’17 results, and while the company saw a slight spike in redemptions immediately after the AC announcement in mid-May, trends returned to normal patterns within a month. Aeroplan alsogrew miles accumulated during both Q2 and in July 2017. Both numbers are wildly inconsistent with a run on the bank scenario, as a run on the bank would be a self-fulfilling prophecy that saw customers materially decrease miles accumulation (no one would want to accumulate miles while they are trying to pull them out desperately) and rush to redeem before the miles devalued / the program disintegrated (i.e. mile redemption would increase exponentially until the program collapses). Since trends had returned to normal by June, and most of the press relating to the Air Canada exit is in the rearview mirror (lots of press on a plan can increase redemptions both by stoking panic and reminding people they should use up all those miles they have sitting in their account), I think it’s safe to say most of the run on the bank risk has passed.
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